Handicapping the Contenders to Replace Bernanke

Jan. 21 (Bloomberg) -- Over the past four years, the
Federal Reserve has become the most important branch of
government. It has acquired unprecedented powers over almost all
aspects of American life. It has also become much more
politicized than at any time in living memory. Expect further
attacks on its independence and integrity at election time. The
spirit of Andrew Jackson lives on.

And now we see clear signals that the Fed is likely to have
a new chairman soon. Who will run the central bank and what does
the choice of top leadership mean for the country?

The recent expansion of the Fed’s powers is ironic, because
the decade before 2008 was hardly the organization’s most
glorious. Monetary policy was arguably too loose for too long
after the dot-com bust and the Sept. 11 attacks. The Fed’s
light-touch approach to financial regulation failed completely.
And the regulator drank the Kool-Aid of the Basel II
international banking rules -- believing in the “advanced
approaches” that let banks design their own model-based capital
levels, which turned out to be woefully inadequate.

The Fed also failed to protect consumers and homeowners
from rapacious practices in parts of the financial sector. And
it spectacularly neglected to consider systemic risk and the
ways a real-estate price boom could lead to overborrowing that
would bring down the macroeconomy. (Amir Kermani, a doctoral
student at the Massachusetts Institute of Technology, has an
excellent new paper that is relevant for understanding these
kinds of dynamics.)

Credit Boom

In fact, it is hard to find an aspect of the Fed’s
activities that went well during the credit boom. Yet the
central bank is now more powerful than ever. How did this
happen?

The explanation lies partly in the extraordinary measures
taken by Chairman Ben Bernanke and his colleagues -- both as the
crisis manifested itself in the fall of 2008 and as the economy
staggered along beginning in 2009. (For more on what happened
and why, I recommend David Wessel’s book, “In Fed We Trust.”)

Harvey Rosenblum and Richard Fisher of the Dallas Fed write
about the “blob that ate monetary policy,” by which they mean
that undercapitalized megabanks became so badly broken that the
ordinary transmission mechanisms of monetary policy no longer
worked. It wasn’t enough to cut short-term interest rates; if
the Fed wanted to help the economy, it needed to take more-dramatic steps.

Fast-forward to early 2013: Through its current and
expected asset purchases, the Fed controls almost the entire
yield curve, meaning the benchmark “risk-free” interest rates
paid on Treasury debt of all maturities (certainly up to the 10-year bond and arguably beyond).

But the change in Fed operating doctrine is much more
profound. In principle, as a result of the Humphrey-Hawkins
legislation in the 1970s, the Fed cared about unemployment as
well as inflation. In practice, the Fed was much more focused on
inflation. Now, however, we have an explicit unemployment target
for the first time.

And the Fed has also assumed greater powers vis-a-vis the
financial system. It’s true that the Dodd-Frank reform
legislation also empowered the Federal Deposit Insurance
Corporation to handle the failure of financial institutions. And
now there is a Financial Stability Oversight Council, headed by
the Treasury secretary.

‘Living Wills’

In reality, though, the Fed controls key parameters
regarding the safety of big banks -- including how much equity
funding they have and the structure of their debt. It is also in
charge of determining whether banks have viable “living wills”
that would allow any potential failure to be handled through
bankruptcy. And the Fed is very much involved in deciding
whether any nonbank financial institutions should be regarded as
“systemic” and thus subject to tighter regulation. Don’t hold
your breath for serious progress on any of these missions.

The Fed is powerful today for two reasons. On the macro
side, there is no alternative. Fiscal policy is off the table as
an instrument for stimulating the economy: You might be for or
against, but nothing is going to happen. You might think
monetary policy is too loose or too tight, but there is no
denying that these decisions are currently of paramount
importance.

On the regulatory side, all the other regulators have
problems. The Office of Thrift Supervision was abolished,
thankfully, by Dodd-Frank. The Office of the Comptroller of the
Currency may be improving under new leadership but it has a
tawdry history of being captured by big banks. And the
Securities and Exchange Commission has become a sad shadow of
its former self.

The FDIC did have a relatively good crisis, but it remains
focused on deposit insurance -- and has been handed the
difficult, messy business of potentially “resolving” failing
megabanks.

Politicians on both left and right feel increasingly
uncomfortable about decision making at the Federal Reserve --
calling now for an audit of the interest-rate-setting process in
the Federal Open Market Committee.

The Fed is full of smart people with a great deal of
integrity. But some parts of the system have become too close to
powerful interests on Wall Street, undermining the political
legitimacy of the more independent parts.

Bernanke will probably step down when his term as chairman
of the Board of Governors expires in early 2014. He could stay,
but the main lesson from the cult of former Chairman Alan
Greenspan is that more than two terms isn’t healthy for the
organization or the country. Future chairmen should be limited
to eight years in office.

Leading Candidates

There are three plausible candidates to take over.

Janet Yellen, the current vice chairman, must be considered
the front-runner. Support her if you like the current trajectory
of the Fed with expansionary macro policy and a go-slow approach
to regulation. Yellen is a very accomplished economist. But
should the Fed continue to disregard the risks of inflation and
understate the danger of too-big-to-fail banks? Most of the
history of central banking -- including the first 100 years of
Fed experience -- suggests that this can become a toxic
combination of mistakes.

Timothy Geithner, who is stepping down as Treasury
secretary, wants the job of Fed chairman. Yet he was head of the
New York Fed during the disastrous boom phase and remains
closely associated with the Robert Rubin-Citigroup wing of the
Democratic Party. His doctrine of “overwhelming force” over the
past four years can be translated into plain English as
“unconditional bailouts for big banks.” This is unlikely to fly
on Capitol Hill.

Fisher of the Dallas Fed represents a different view, more
concerned about the potential resurgence of inflation and
pressing for tougher action on the dangerous megabanks. Everyone
should read his latest speech on how to reform the banking
system.

Fisher warrants serious consideration for the position of
chairman of the world’s most powerful central bank.

(Simon Johnson, a professor at the MIT Sloan School of
Management as well as a senior fellow at the Peterson Institute
for International Economics, is co-author of “White House
Burning: The Founding Fathers, Our National Debt, and Why It
Matters to You.” The opinions expressed are his own.)